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Why Zero Coupon Bonds Can Add Up To Much More Than Zero

Zero coupon bonds (sometimes called zeroes for short) have been around for 30 years, having first been introduced as a fixed-income investment option in 1982. Due to their unique structure and characteristics, zeroes remain an attractive investment option for many individuals.

How They Work

Zeroes derive their name from the fact that they have no coupon, which means they do not make periodic (e.g., semiannual) interest payments like most other bonds do. Instead, investors receive a payout of the full face amount of the bond when it matures, which is equal to the initial principal amount invested plus the interest earned at the stated yield.

Zero coupon bonds are sold at a discount, which means the price an investor pays for a zero will likely be substantially less than the face amount. For example, a 20-year zero coupon bond with a $20,000 face amount could be bought for about $6,757 (assuming a 5.5% interest rate, compounded semiannually). The investor will earn about $13,243 in interest over the term of the bond, receiving $20,000 when the bond matures in 20 years.

The benefits of zero coupon bond investing may be enhanced even more by purchasing zero coupon tax-free municipal bonds. Since the interest on these bonds is free from Federal income taxes—and in many cases, state and local income taxes as well—they may provide higher returns on a net basis than comparable taxable securities. Generally, investors must purchase municipal bonds from their home state to be free of Federal, state and local income taxes. With a taxable zero coupon bond, for example, investors must pay taxes on the interest accrued each year even though the interest hasn’t been paid out yet. Investors must come up with the cash to pay this tax out of pocket.

How They May Be Used

Zero coupon municipal bonds feature a wide range of maturities—from one to 40 years—which enables you to time the maturity to coincide with future financial needs. This may make them an attractive option for investors seeking long-term capital accumulation to meet long-term savings goals, such as:

• Retirement— By purchasing a zero coupon municipal bond, you can know exactly how much money you will have on the date of your retirement, or some future date after retirement, if you prefer. Note: Tax-free zero coupon munis may be a good vehicle to supplement another retirement savings program (like a 401(k) or IRA), but they are not generally suitable investments for these plans because these plans already enjoy tax-advantaged status.

• Funding children’s or grandchildren’s college educations— Again, the predictability of the payout can make a zero coupon muni useful for education funding, since you can structure the maturity to coincide with the start of your child or grandchild’s college education.

• Gifting assets— By gifting assets today (using the annual gift tax exclusion of $13,000 in 2012) via a zero coupon muni bond, those assets can continue to grow for heirs tax-free in the future.

• Supporting elderly parents— If you anticipate that you might need to help support your aging parents somewhere down the road, you can buy a zero coupon municipal bond today and lock in a fixed payout amount some year in the future.

It’s important to note that zero coupon bonds are not without risk. To help investors gauge credit risk, zero coupon bonds are rated by major rating services such as Moody’s Investors Service and Standard & Poor’s. Generally, bonds that are rated at least BBB by Standard & Poor’s, or Baa by Moody’s are considered to be “Investment Grade” and may be suitable for preservation of capital.

• The Moody's ratings in the following ratings explanations are in parenthesis.

AAA (Aaa) – The highest rating assigned by Moody’s and S&P. Capacity to pay interest and repay principal is extremely strong.

AA (Aa) – Debt has a very strong capacity to pay interest and repay principal and differs from the highest rated issues only in a small degree.

A – Debt rated “A” has a strong capacity to pay interest and repay principal, although it is somewhat more susceptible to the adverse affects of changes in circumstances and economic conditions than debt in higher-rated categories.

BBB (Baa) – Debt is regarded as having an adequate capacity to pay interest and repay principal. These ratings by Moody’s and S&P are the “cut-off” for a bond to be considered investment grade. Whereas debt normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal in this category than in higher-rated categories.

BB (Bb), B, CCC (Ccc), CC (Cc), C – Debt rated in these categories is regarded as having predominantly speculative characteristics with respect to capacity to pay interest and repay principal. “BB” indicates the least degree of speculation and “C” the highest. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or market exposure to adverse conditions and are not considered to be investment grade.

D – Debt rated “D” is in payment default. This rating category is used when interest payments or principal payments are not made on the date due, even if the applicable grace period has not expired, unless S&P believes that such payments will be made during such grace period.

There are other risks and factors involved in buying zero coupon bonds such as interest rate risk: bonds prices move inversely to interest rates. Rising interest rates normally cause bond prices to decline. Zero coupon bonds are more sensitive to interest rate swings than bonds which pay interest semiannually. Also investors need to consider the impact of inflation on their investments.

Interest earned on certain municipal bonds is subject to the alternative minimum tax (AMT). Investors should consult with their tax preparer or tax advisor to determine if they are subject to AMT.

For more details on these risks and to discuss whether zero coupon bonds might be the right investment for you, please contact David Lerner Associates at (877) 367-5960.

Neither the information nor any statement expressed or implied herein, constitutes solicitation by David Lerner Associates, Inc. for the purchase or sale of any securities.

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